Though LGFVs carry some intrinsic risks, stemming from relatively low levels of transparency and government supervision, they have been integral to China's industrialization process so far. Indeed, they emerged in the early 1990s to enable Shanghai and Guangdong to upgrade their infrastructure in preparation for their industrialization drive.

Both cities suffered from weak technical and institutional capacity and little foreign exchange or domestic credit. By working with the World Bank and the China Development Bank, Shanghai and Guangdong created an innovative institutional structure to facilitate the coordination of stakeholders to deliver specific infrastructure projects, employing the legal and accounting tools of modern corporations. In other words, the LGFV is, at its core, a vehicle for local modernization.

This institutional innovation enabled the reconstruction of hundreds of Chinese cities, connected by airports, highways, high-speed rail, and advanced telecommunication systems. Supported by these structures and linkages, one-third of Chinese cities have attained per capita GDP of more than $10,000.

Moreover, the original LGFVs were not subject to maturity mismatches, because they were funded through long-term China Development Bank loans, with local governments using the fees and taxes they accrued from the completed infrastructure to cover operating costs and service their debt. In this way, LGFVs also helped to create the network linking local markets to global value chains.

But, as is often the case, success led to excess. Massive government stimulus in the wake of the global financial crisis spurred local governments to take loans from Chinese banks to realize dream infrastructure projects, with remote cities attempting to imitate urban showcases like Shanghai or Shenzhen.

In a sense, this was a positive development. After all, leveling the infrastructure gap enlarges the range of options from which people and companies can choose when deciding where to live or establish factories and offices.

But the infrastructure boom was underpinned by the belief that local governments would always have access to easy credit, cheap land, and rising demand. When the market tightened in 2011, many projects' prospects diminished, spurring LGFVs to seek credit in the shadow banking sector, which has caused their borrowing costs to rise and introduced new market-based challenges to the reform process.

Nonetheless, because China is a net lender to the world, LGFV debt has no global systemic implications. While China's outstanding local government debt totaled 29 trillion yuan ($4.7 trillion) at the end of 2011, its land and fixed assets are worth some 90 trillion yuan, meaning that even if asset values were written down by half, local governments would remain solvent.

This leaves only the issue of debt servicing. To resolve it, the government has announced fiscal reforms to split revenues between central and local governments and enable local governments to issue long-term municipal bonds.

China's ghost towns and local-government debts are not harbingers of doom. They are bumps on the road to a developed economy, in which excesses will be resolved by the State or the market. In fact, overcoming these challenges will make for a more resilient economy in the long run.

Andrew Sheng is a distinguished fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is director of research at the Fung Global Institute.

Project Syndicate